There’s a dichotomy between the pace of job growth and the
unemployment rate. Our Chief U.S. Economist Michael Gapen and
Global Head of Macro Strategy Matthew Hornbach analyze how the
Fed might address this paradox.
Read more insights from Morgan Stanley.
----- Transcript -----
Matthew Hornbach: Welcome to Thoughts on the
Market. I'm Matthew Hornbach, Global Head of Macro Strategy.
Michael Gapen: And I'm Michael Gapen, Morgan
Stanley's Chief U.S. Economist.
Matthew Hornbach: Today – a look back at last
week’s meeting of the Federal Open Market Committee or FOMC, and
the path for rates from here.
It's Tuesday, August 5th at 10am in New York.
Mike, last week the Fed met for the fifth time this year. The
committee didn't provide a summary of their economic projections,
but they did update their official policy statement. And of
course, Chair Powell spoke at the press conference. How would you
characterize the tone of both?
Michael Gapen: Yeah, at first the statement I
thought took on a slightly dovish tone for two reasons. One,
unexpected; the other expected. So, the committee did revise down
their assessment of growth and economic activity. They had
previously described the economy as growing at a quote, ‘solid
pace,’ and now they said, you know, the incoming data suggests
that growth and economic activity moderated.
So that's true. That's actually our view as well. We think the
data points to that. The second reason the statement looked a
little dovish, and this was expected is the Fed received two
dissents. So, Governors Bowman and Waller both dissented in favor
of a 25 basis point rate cut at the July meeting.
But then the press conference started. And I would characterize
that as Powell having at least some renewed concerns around
persistence of inflation. So, he did recognize or acknowledge
that the June inflation data showed a tariff impulse. But I'd say
the more hawkish overtones really came in his description of the
labor market, which I know were going to get into.
And we've been kind of wondering and, you know, asking implicitly
– is the Fed ever going to take a stand on what constitutes a
healthy and/or weak labor market? And Powell, I think put down a
lot of markers in the direction; that said, it's not so much
about employment growth, it's about a low unemployment
rate.
And he kept describing the labor market as solid, and in healthy
condition, and at full employment. So, the combination of that
suggests it's a higher bar, in our mind, for the Fed to cut in
September.
Matthew Hornbach: And on the labor market, if we
could dig a little bit deeper on that point. It did seem to me
certainly that Powell was channeling your views on the labor
market.
Michael Gapen: Well, I wish I had that power but
thank you.
Matthew Hornbach: Well. I'd like to now channel
your views – and of course his views – to our listeners. Can you
just go a little bit deeper into this dichotomy that you've been
highlighting between the pace of job growth and the unemployment
rate itself?
Michael Gapen: Yeah. Our thesis and what we've
laid out coming into the year, and we think the data supports, is
the idea that immigration controls have really slowed growth in
the labor force. And what that means is the break-even rate of
employment has come down.
So even as economic growth has slowed and demand for labor has
slowed, and therefore employment growth has slowed – the
unemployment rate has stayed low, and there's some paradox in
that. Normally when employment growth weakens, we think the
economy's rolling over; the Fed should be easing.
But in an environment of a very slow growing labor force, the two
can coincide. And there's tension in that, we recognize. But our
view is – the more the administration pushes in the direction of
restraining immigration, the more likely it is you'll see the
combination of low employment growth, but a low unemployment
rate. And our view is that still means the labor market is tight.
Matthew Hornbach: Indeed, indeed. Just one last
question from me. How are you thinking about the Fed's policy
path from here? In particular, how are you looking at the
remaining data that could get the Fed to cut rates in September?
Michael Gapen: Yeah, I think that there's no
magic sauce here, if you will; or secret sauce. Powell, you know,
essentially is laying out a case where it's more likely than not
inflation will be deviating from the 2 percent target as tariffs
get passed through to consumer prices. And the flag that he
planted on the labor market suggests maybe they're leaning in the
direction of thinking the unemployment rates is likely to stay
low.
So, we just need more revelations on this front. And the gap
between the July and the September FOMC meetings is the longest
on the Fed's calendar. So, they will see two inflation reports
and two labor market reports. And again, it just to provide
context and color, right? What I think Powell was doing was
positioning his view against the two dissents that he received.
So where, for example, Governor Waller laid out a case where
weaker employment growth could justify cuts, Powell was
reflecting the view of the rest of the committee that said,
‘Well, it's not really employment growth, it's about that
unemployment rate.’
So, when these data arrive, we'll be kind of weighing both of
those components. What does employment growth look like going
forward? How weak is it? And what's happening to that
unemployment rate?
So, if the Fed's doing its job, this shouldn't be magic. If the
labor market's obviously rolling over, you'll get cuts later this
year. If not, we think our view will play out and the Fed will be
on the sideline through, you know, early 2026 before it moves to
rate cuts then.
So Matt, what I'd like to do is kind of turn from the economics
over to the rates views. How did the rates market respond to the
meeting, to the statement, to the press conference? How are you
thinking about the market pricing of the policy path into your
end?
Matthew Hornbach: So initially when the
statement was released, as you noted, it had a dovish flavor to
it. And so, we had a small repricing in the interest rate market,
putting a little bit of a higher probability, on the idea that
the Fed would lower rates in September. But then as Chair Powell
began the press conference and started to articulate his views
around both inflation and the labor market we saw the market take
out some probability that the Fed would lower rates in September.
And where it ended up at the end of that particular day was
putting about a 50 percent probability on a rate cut and as a
result of 50 percent probability of no rate cut; leaving the data
to really dictate where the pricing of that meeting would go from
there.
That to me speaks to this data dependence of the Fed, as you've
discussed. And I think that in the coming weeks we get more of
this data that you talked about, both on the inflation side of
the mandate and on the labor market side of the mandate. And
ultimately, if they end up, going in September, I would've
expected the market to have priced most of that in, ahead of the
meeting. And if they end up not cutting rates in September, then
naturally the market will have moved in that direction ahead of
time.
And again, I think what ends up happening in September will be
critical for how the market ends up pricing the evolution of
policy in November and December. But to me, what I think is more
interesting is your view on 2026. And in that regard, the market
is still some distance away from your view, that the Fed goes
about 175 basis points in 2026.
Michael Gapen: Yeah, I mean, we're still
thinking the lagged effects of tariffs and immigration will slow
the economy enough to get more Fed cuts than the market's
thinking. But, you know, we'll see if that happens. And maybe
that's a topic we can turn back to in upcoming Thoughts on the
Market.
But what I'd like to do is ask you this. I've been reading some
of your recent work on term premiums. And in my view, had this
really interesting analysis about how the market prices Fed
policy and how U.S. Treasury yields then adjust and move.
You highlighted that Treasury yields built in a term premium
after April 2nd. What's happening with that term premium today?
Matthew Hornbach: Yeah. The April 2nd Liberation
Day event catalyzed an expansion of term premia in the Treasury
market. And ultimately what that means is that Treasury yields
went up relative to what people were thinking about the path of
Fed policy, And of course, the risks that they were thinking
about in the month of April were risks related to trade policy.
Those risks have diminished somewhat, I would argue in the
subsequent months as the administration has been announcing deals
with some of our trading partners. And then the market's focus
turned to supply and what was going to happen with U.S. Treasury
supply. And then, of course, the reaction of investors to that
coming supply.
And I would say, given what the Treasury announced last week,
which was – it had no intention of raising supply, in the next
several quarters. In our view is that the U.S. Treasury will not
have to raise supply until the early part of 2027. So way off in
the distance. So, investors are becoming more comfortable taking
on duration risk in their portfolios because some of that
uncertainty that opened up after April 2nd has been put away.
Michael Gapen: Yeah, I can see how the
substantial tariff revenue we're bringing in could affect that
story. So, for example, I think if you annualize the run rates on
tariffs, you'll get something over $300 billion in a 12-month
period. And that certainly will have an impact on Treasury
supply.
Matthew Hornbach: Indeed. And so, as we make our
way through the month of August, we'll get an update to those
tariff revenues. And also, towards the end of August, we will
have the economic symposium in Jackson Hole, where Chair Powell
will give us his updated thoughts on what is the outlook for the
economy and for monetary policy. And Mike, I look forward to
catching up with you after that.
Thanks for taking the time to talk today.
Michael Gapen: Great speaking with you Matt.
Matthew Hornbach: And thanks for listening. If
you enjoy Thoughts on the Market, please leave us a review
wherever you listen and share the podcast with a friend or
colleague today.
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